April 2009

For investors and regulators interested in the CDS market the greatest need is for increased transparency, writes Rhodri Preece...

Merely a month into the market turmoil that began last September, worldwide efforts were already underway to deal with uncertainty and volatility created by credit default swaps (CDSs). In Brussels Charlie McCreevy, European internal market commissioner, was calling for industry proposals on how to mitigate the risks from credit derivatives. Simultaneously, in the US, the Securities and Exchange Commission, the Federal Reserve Board, and the Commodity Futures Trading Commission were working together to push for the creation of a central clearing counterparty to reduce the risks highlighted by the market dysfunction.

These separate but complementary efforts indicated the growing global recognition of the systemic implications of counterparty risk and opacity in the CDS market. The goal for regulators was to transform the over-the-counter and privately negotiated nature of this ten-year-old derivatives market by allowing much-needed transparency into its pricing and clearing.

Not surprisingly, regulators’ concerns haven’t escaped the attention of market participants, as dealers and firms have stepped up efforts to improve their risk management and back-office operations to ensure trades clear effectively and efficiently. Most notably, these private efforts have focused on portfolio compression in order to provide a net position in a given contract for each counterparty to smooth trade processing.

These efforts are occurring as open interest in the CDS market has retrenched. The notional amount of open contracts has
fallen to less than $30 trillion (€23.5 trillion) from a peak of $62 trillion at the end of 2007, according to the Depository
Trust & Clearing Corporation’s Trade Information Warehouse.

The problem for investors in more obscure CDS instruments, however, was that these factors were not present during the market’s peak. Consequently, many were left unable to gauge the value of their holdings when the market slide began last year.

Moreover, regulators are concerned that the lack of transparency and other market functions may enable some participants to manipulate the market for a given ‘reference entity’, creating the perception of heightened credit risk. A simultaneous short position in the entity’s shares might enable a market participant to profit from the subsequent share price decline. Intuitively, this scenario could only occur (at least to a material extent) if CDS spreads were a leading indicator of equity prices.

Fortunately for regulators and market participants alike, the data suggests that this has not been the case, at least through mid-October. A comparison of the share price of financial institutions with their CDS* spreads indicates that the two measures were moving in tandem, making it difficult to manipulate the market in this fashion.

This relationship was most notably evident with Lehman Brothers prior to its failure. While the spikes in its CDS spread support the notion that this market is volatile and prone to over-shooting, the symmetry of price formation suggests that information is impounded in CDS spreads in much the same fashion as equity prices. Moreover, judging by the absence of significant leading/lagging price movements, this example reveals little scope for market abuse.

Significantly, single-name CDS contracts at the five-year maturity (the most liquid segment) are typically the simplest, most transparent form of CDS, with a high degree of standardisation in contract terms. Not ironically, this supports the view that more standardised contracts improve transparency and do a better job setting market prices.

Ultimately, policy makers and regulators worldwide should now work to ensure that these initiatives for greater transparency and for central clearing are implemented as swiftly and efficiently as possible.
* CDS data source: Markit

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